The appetite for Web-based video in China has prompted a merger between two of the country’s top website rivals. Youku (NYSE:YOKU[1]) and Tudou (NASDAQ:TUDO[2]) have agreed to form a new online television company called Youku Tudou in a stock transaction worth about $1 billion. If shareholders approve the deal, it likely will close in the third quarter. The resulting entity will continue to trade in the United States under Youku’s ticker, YOKU.

Youku and Tudou began as Chinese versions of YouTube, initially relying on users for video content. Their services quickly evolved, though, and they began delivering content typical of TV stations, including imported programs shown alongside their own productions, and they attracted the affluent urban viewers coveted by advertisers.

Earlier this year the companies sued each other, claiming misuse of content. But both companies are losing money and burdened by the high cost of programming and maintaining high-bandwidth Internet access. The partnership could move them into a dominant position in China’s Internet TV market with the biggest online video library of professionally licensed material and user-generated content. Beijing research firm Analysys International estimates that as of fourth quarter 2011, Youku had 21.8% of China’s online TV market, while Tudou had 13.7 %.

A little less room for Netflix

The merger between Youku and Toudou will make it harder for streaming video provider Netflix (NASDAQ:NFLX[3]), which has about 23 million subscribers in China, to further expand in the country, where both Youku and Toudou have been able to strike deals to simulcast some programming and win shorter release dates on new Chinese films. One example is Youku’s airing of “Aftershock,” a 2010 Chinese film about the 1976 Tangshan earthquake, one month after its theater debut.

But the combined company will give TV programmers such as News Corp. (NASDAQ:NWS[4]) and Hollywood production houses such as Lionsgate Entertainment (NYSE:LGF), which recently struck deals with Youku, a broader outlet for their programming. In January Youku and Twentieth Century Fox Home Entertainment announced a deal allowing Youku to license 250 titles of new releases and library films for Youku Premium, Youku’s on-demand platform.

Earlier this month, Youku signed a licensing agreement with Lionsgate that grants it the right to offer 200 Lionsgate titles to its viewers, including “Hotel Rwanda” and “Monster’s Ball.” The shows will become available to users on an ad-supported basis via the Youku Movies Channel.

An intensely competitive sector

Although it heavily censors state-owned newspapers, TV, and radio stations, the Chinese government seems to have adopted a mostly hands-off approach to the private Chinese Internet TV industry, likely in hopes that it will help propel development in China’s high-tech industry. The government’s relatively light touch has allowed the mostly fragmented industry– there are 10 companies competing in online video — to flourish in one of the world’s largest markets.

Youku estimates that more than 420 million Chinese people have Internet access, including 316 million who use it to watch online video and 277 million who are mobile Internet users. Beijing Media consulting firm CCM Intelligence expects the number of Chinese who watch TV online to exceed 445 million by the end of 2012.

But the Associated Press points out that the rapid growth of online TV threatens to erode viewership of the country’s state-run TV offerings, which are used by Beijing to mold public opinion. If the merger goes through, the combined company will have more than one-third of the market, and that raises the possibility that China’s government might tighten controls to protect its own media outlets.